Scholars

The purpose of the 1933 Banking Act—aka Glass-Steagall—was to prevent the exposure of commercial banks to the risks of investment banking and to ensure stability of the financial system. A proposed solution to the current financial crisis is to return to the basic tenets of this New Deal legislation.

Senior Scholar Jan Kregel provides an in-depth account of the Act, including the premises leading up to its adoption, its influence on the design of the financial system, and the subsequent collapse of the Act’s restrictions on securities trading (deregulation). He concludes that a return to the Act’s simple structure and strict segregation between (regulated) commercial and (unregulated) investment banking is unwarranted in light of ongoing questions about the commercial banks’ ability to compete with other financial institutions. Moreover, fundamental reform—the conflicting relationship between state and national charters and regulation—was bypassed by the Act.

The purpose of the 1933 Banking Act—aka Glass-Steagall—was to prevent the exposure of commercial banks to the risks of investment banking and to ensure stability of the financial system. A proposed solution to the current financial crisis is to return to the basic tenets of this New Deal legislation.

Senior Scholar Jan Kregel provides an in-depth account of the Act, including the premises leading up to its adoption, its influence on the design of the financial system, and the subsequent collapse of the Act’s restrictions on securities trading (deregulation). He concludes that a return to the Act’s simple structure and strict segregation between (regulated) commercial and (unregulated) investment banking is unwarranted in light of ongoing questions about the commercial banks’ ability to compete with other financial institutions. Moreover, fundamental reform—the conflicting relationship between state and national charters and regulation—was bypassed by the Act.

Past experience suggests that multifunctional banking is the leading source of financial crisis, while large bank size contributes to contagion and systemic risk. This indicates that resolving large banks will not solve the problems associated with multifunctional banking—a conclusion reached after every financial crisis, and one that should apply to the present crisis as well. Senior Scholar Jan Kregel observes that it is important to recognize that past solutions may not be appropriate for present conditions. The approach to the current financial crisis has been to resolve small- and medium-size banks through the FDIC, while banks considered “too big to fail” are given direct and indirect government support. Many of these large government-supported banks have been allowed to absorb smaller banks through FDIC resolution, creating even larger banks. As these institutions repay their direct government support, the problem of “too big to fail” is simply aggravated. Thus, the current thrust of government regulatory reform—increased capital and liquidity requirements, and further legislation—is unlikely to lessen the systemic risks these institutions pose.

What We Can Do Today to Straighten Out Financial Markets

Congress is currently debating new regulations for financial institutions in an effort to avoid a repeat of the recent crisis that brought the banking system to the brink. Some of those proposed changes would be valuable. But what nobody seems to have noticed is that the government already has the power to address some of the most important factors that contributed to the crisis. Today, right now, Washington could change a few key rules and prevent a repeat of the rampant speculation, and possible fraud, that led to so much trouble this last time around.

The use of government fiscal stimulus to support the economy in the recent economic crisis has brought increases in government deficits and increased government debt. This has produced an interest in sustainable government debt and the role of deficits in the economy. This paper argues in favor of a concept of "responsible" government policy, referring to positions held by Franklin and Marshall Professor Will Lyons. The idea is that government should be responsible to the needs and desires of its citizens, but that this should go beyond physical security and education, to economic security. Building on the fallacy of composition and misplaced concreteness, it suggests that in an integrated macro system an increased desire to save on the part of the private sector will be self-defeating unless the government acts in a responsible manner to support those desires. This can only be done by government dissaving via an expenditure deficit. The outstanding government debt simply represents the desires of the public to hold safe financial assets, and can only be unsustainable if the public’s desires change. The government should always be responsive to these desires, and adjust its expenditure policy.